How do Convertible Notes Work?
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Convertible notes are a hybrid financing instrument that allows debt to be converted into equity at a trigger event, such as investment or liquidation, turning note holders into shareholders. They typically feature a discount to compensate early investors for risk and a cap to limit maximum conversion valuation. This financial tool is commonly used by startups for seed or bridge funding and involves negotiations between founders, original shareholders, and professional investors.
How do Convertible Notes Work?
- 1. How do Convertible Notes Work? Equity Debt Convertible Notes Straight equity, the investors receive shares directly in the company Investors receive a monthly payment and they are the first ones paid in case of bankruptcy Hybrid instrument in which debt is converted into Equity at a trigger event The Trigger Event The trigger event triggers the conversion of the debt into equity, meaning that the convertible notes become shares and the convertible note holders become shareholders. Types of trigger events • Investment • Liquidation • Expiry date The Players The Founders Other Original shareholders Convertible Notes Investors PROFESSIONAL INVESTORS are used to convertible notes for seed or bridge funding VC or later stage investors The DISCOUNT The CAP The discount is set to compensate convertible note holders for the risk of investing at an earlier stage. The Founders Convertib le Notes Investors THE COMPANY NEEDS MONEY TO GROW TRIGGER EVENT 1 Valuation is set at the trigger even negotiations SET VALUATION 2 Cap and discount are applied APPLY DISCOUNTS 3 Final Equity is given to convertible notes holder GIVE EQUITY 4 Equity is given to Trigger Event Investors NEW INVESTORS Average Discount Rate (Equidam) 32,5% A Cap is set to lock the maximum valuation of conversion. This protects convertible note holders in case the valuation grows too much. NEW CAP TABLE IS FINALIZED Other Original sharehold ers VC / New Investors CREDITS: Credits for this infographic go to Daniel Faloppa and the whole team at www.equidam.com What is a convertible note: https://www.equidam.com/practical-advice-pricing-convertible-note/ Average convertible note discount: https://www.equidam.com/discount-rate-for-a-convertible-note/ Legal and financial resources for convertible notes: https://www.equidam.com/